T.C. Memo. 2001-106
UNITED STATES TAX COURT
JAMES TINNELL, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 20318-97. Filed May 4, 2001.
W. Leslie Sully, Jr., for petitioner.
Paul L. Dixon, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
MARVEL, Judge: Respondent determined the following
deficiencies, additions to tax, and penalties with respect to
petitioner’s Federal income taxes:1
1
All section references are to the Internal Revenue Code in
effect for the years in issue, and all Rule references are to the
Tax Court Rules of Practice and Procedure. Monetary amounts are
rounded to the nearest dollar.
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Additions to tax and penalties
Sec. Sec. Sec.
Year Deficiency 6651(a)(1) 6654 6662(a)
1991 $146,062 $15,132 $10,810 $29,212
1992 100,517 8,041 4,384 20,103
1993 405,936 38,703 4,837 81,187
1994 134,217 15,582 10,107 26,843
Following concessions,2 the issues for decision are:3
(1) Whether petitioner’s mining activity for 1991, 1992,
1993, and 1994 constituted an activity engaged in for profit
within the meaning of section 183; and
(2) whether petitioner is liable for the accuracy-related
penalty due to negligence under section 6662(a) for each year in
issue.
2
In a Stipulation of Settled Issues filed with the Court,
the parties agreed: (1) Petitioner’s claims of alimony paid in
1991 and 1992 were overstated by $57,595 and $600, respectively;
(2) petitioner understated capital gain in 1992 by $23,380; (3)
petitioner understated royalty income from Zila, Inc., in 1992 by
$3,726; and (4) petitioner is not liable for additions to tax
pursuant to sec. 6651(a)(1) or sec. 6654, as determined in
respondent’s notices of deficiency, for 1991, 1992, 1993, and
1994. In a second Stipulation of Settled Issues filed with the
Court, the parties agreed: (1) In 1991, petitioner was entitled
to claim a net operating loss deduction of $128,461 instead of
the $23,995 originally claimed; (2) in 1993, petitioner
originally claimed a net operating loss carryforward deduction of
$101,898, and the parties agreed there is no net operating loss
carryforward available for deduction, unless and except to the
extent any determination by the Court with respect to the
Schedule C mining activity in 1991 or 1992 results in a
carryforward of net operating loss; and (3) in 1993, petitioner
understated ordinary income from the exercise of stock options in
Zila, Inc., by $282,979.
3
The only other issues for decision are computational.
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FINDINGS OF FACT4
The parties have stipulated some of the facts, which we
incorporate in our findings by this reference. Petitioner was a
resident of Las Vegas, Nevada, when the petition in this case was
filed.
Petitioner graduated from the University of Arkansas School
of Medicine in 1962. In 1965, petitioner began practicing
medicine in Lewisburg, Tennessee. Five years later, petitioner
relocated his medical practice to Chattanooga, Tennessee.
Petitioner has been engaged in the practice of medicine at all
relevant times.
I. Delta Roofing Mills
In or about 1973, petitioner and his father purchased Delta
Roofing Mills, a roofing manufacturing business in Slidell,
Louisiana, for approximately $1 million. Petitioner participated
in the management and marketing of Delta Roofing Mills, which
tripled its gross sales while petitioner and his father owned it.
Five years after petitioner and his father purchased Delta
Roofing Mills, they sold it to Republic Gypsum Corp. for
approximately $3 million and split the net sale proceeds.
4
In his opening brief, petitioner set forth “Proposed
Findings of Fact” that were in essence ultimate findings of fact.
By neglecting to follow Rule 151(e), which requires petitioner to
include numbered proposed findings of fact, petitioner has
“assumed the risk that we have not considered the record in a
light of * * * [his] own illumination.” Monico v. Commissioner,
T.C. Memo. 1998-10.
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II. Zila Pharmaceuticals, Inc.
In 1974, petitioner relocated his medical practice from
Chattanooga, Tennessee, to Las Vegas, Nevada. In conjunction
with his medical practice, petitioner began doing research on
herpes. During the late 1970's, petitioner invented a cream
called Herpaway (cream) for the topical treatment of herpes.
In September 1980, petitioner and his partner, Dr. Edwin D.
McKay, formed a pharmaceutical manufacturing business called Zila
Pharmaceuticals, Inc., a Nevada corporation, to manufacture and
distribute the cream.5 Effective September 1, 1988, Zila
Pharmaceuticals, Inc., became a wholly owned subsidiary of Zila,
Inc. (Zila), a Delaware corporation. Today, the cream is called
Zylactin and is being sold as an over-the-counter treatment for
herpes. At the time of trial, Zila had over 200 employees and a
market capitalization of approximately $200 million. At all
relevant times, petitioner has received royalties from Zila from
sale of the cream.
III. Petitioner’s Mining Activities
A. Commencement of Petitioner’s Mining Activities
In 1978, petitioner began reading prospecting books and
became interested in mining. Petitioner attended shows and
seminars about mining and purchased numerous books on geology and
5
Before the formation of Zila Pharmaceuticals, Inc.,
petitioner acquired a corporate shell company called Dusenberg
Replicar, which later became Zila Industries.
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mining at the University of Nevada bookstore. Petitioner also
learned how to read geological mining maps. Petitioner began
searching for gold and other precious metals on Federal land in
Clark County, Nevada. By 1979, petitioner began locating mining
claims near Searchlight, Nevada.
On March 5, 1980, petitioner formed Jetco Enterprises, Inc.
(JEI), a Nevada corporation. Although petitioner apparently
planned to conduct his mining activities through JEI at some
point, petitioner did not use JEI during the years at issue or in
prior years to report the results of his mining activities.
Instead, petitioner conducted his mining activities as a sole
proprietorship doing business as Jetco Mining.6 Over the years,
petitioner employed his two sons, his daughter, and an ex-
brother-in-law in his mining activity.7
6
JEI, through and including the years at issue, did not file
Federal income tax returns. JEI, however, issued shares of
stock, held board meetings, kept minutes of corporate activities,
and otherwise observed all the formalities of a corporation. At
the time of trial, JEI was in good standing with the secretary of
state of Nevada. Petitioner is the sole shareholder and
president of JEI. Petitioner’s sons, L.R. Tinnell and Jaye E.
Tinnell, are secretary and treasurer, respectively. JEI’s fiscal
tax year ends Jan. 31.
7
At the time of trial, petitioner still employed his two
sons in his mining operation.
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During 1980, petitioner located and staked at least 47 lode
mining claims in Clark County, Nevada.8 During the 1980's,
petitioner conducted exploration and development activities with
respect to his claims. As of February 2000, petitioner had on
file and of record more than 300 lode mining claims. A “Resource
Management Plan” map, dated August 1, 1997, prepared by and for
the U.S. Department of the Interior, Bureau of Land Management
(BLM), indicated there is “high mineral potential” on and around
petitioner’s mining claims.
B. Petitioner’s Early Efforts To Generate Income From
Mining
Petitioner engaged in business discussions regarding his
mining activities with various parties and entities. In December
1982, petitioner discussed the possible sale of ore to Cash
Industries of Idaho (Cash Industries) for processing at Cash
Industries’ facilities. During December 1982 and January 1983,
petitioner and Cash Industries conducted a sampling program and
numerous assays on petitioner’s claims. No sale resulted.
In April 1983, petitioner engaged in discussions with Lud
Carrao, the owner of a construction company, regarding a joint
venture in mining. The venture was subject to proof of the
economic and commercial value of petitioner’s claims. Petitioner
8
Most of petitioner’s claims were located in the Newberry
Mountains southeast of Searchlight, Nevada, which is an area
recognized for its high mineral potential.
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engaged in negotiations with Mr. Carrao, but no agreement was
reached.
In May 1983, Century Capital Corp. explored investment in
petitioner’s mining venture but never raised any money for the
venture.9
In November 1983, petitioner engaged in discussions with
Canorex International, Inc., of Colorado regarding a lease of
petitioner’s claims. No agreement was reached.
In 1983 and 1984, petitioner pursued a gold mining venture
in Lochiel, Arizona, on the U.S.-Mexico border. The operation
produced an ounce to an ounce and a half of gold per day. The
price of gold had fallen significantly, however, and the
operation was not profitable. Soon thereafter, the operation was
shut down.
Upon discontinuing mining in Arizona, petitioner moved his
equipment to Colorado and began another mining operation with a
“guy with a placer operation”. The Colorado “guy” misrepresented
the amount of gold available, however, and petitioner terminated
his involvement in the operation.
Petitioner returned to Las Vegas, Nevada, and, disappointed
with the last two unsuccessful ventures in Arizona and Colorado,
did not attempt to develop any mining ventures except his own
9
Century Capital Corp. was also involved in the private
placement of Zila.
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claims. Petitioner continued to talk to people about mining, to
read about mining, and to go to meetings about mining during this
period.
In 1986, petitioner and a local real estate attorney,
Darrell Clark, representing Great Western Basin Corp. (Great
Western), negotiated a mining lease. The lease was conditioned
on testing and sampling of petitioner’s claims. An independent
geologist prepared a report for Great Western that set forth
numerous recommendations and conclusions. In September 1986,
petitioner and Great Western entered into a lease whereby
petitioner agreed to lease his mining claims to Great Western for
the purposes of prospecting, exploring, drilling, mining, and
operating the property for ores and minerals. Great Western made
no payments to petitioner, however, and defaulted on the lease.
In 1988, petitioner began consulting with Kent Kjelberg at
the Rattlesnake Mine in California. Petitioner provided
extensive equipment and knowledge to the Rattlesnake Mine.
Petitioner was not paid for the use of his equipment or for the
information he provided, but he was promised a portion of the
income produced from the Rattlesnake Mine. Ultimately,
petitioner received only an old grader.
In or about 1988, petitioner began to disengage from his
pharmaceutical activities at Zila and began spending more time on
his mining activities.
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C. Petitioner’s Mining Plan of Operations
On May 5, 1989, petitioner submitted a proposed mining plan
of operations to the BLM for approval.10 On January 12, 1993,
the BLM approved petitioner’s plan of operations. During the
BLM’s investigation of petitioner’s plan of operations, from 1989
through 1993, petitioner incurred substantial expenditures to
develop a production mill, purchase an induction furnace,11 and
10
In order to initiate mining activity on Federal land, a
claimant must first file a 2-week notice, which allows the
claimant to disturb up to 2 acres of land per year. If the
claimant desires to disturb more than 2 acres, a plan of
operations must be approved by the BLM. Once a plan of
operations is filed, the BLM conducts an investigation before
approving the plan. In petitioner’s case, the BLM’s
investigation lasted approximately 3 to 4 years, during which
petitioner was allowed to erect facilities on his claims with the
knowledge of the BLM. The expenses incurred in erecting those
facilities are reflected in petitioner’s tax returns for those
years.
11
At some point, petitioner entered into a contract with
Inductotherm to perform a series of test smelts to determine
whether recoveries from his claims could be enhanced through the
use of induction smelting. Inductotherm provided an induction
furnace in Los Angeles, and petitioner and his son L.R. Tinnell
performed a series of seven smelts at Inductotherm’s facilities
(which created doré bars). Petitioner and L.R. Tinnell performed
tests on the doré bars, the results of which were favorable.
Thereafter, petitioner communicated with Union Miniere in
Belgium, which sent a local representative to perform an analysis
on petitioner’s doré bars. On the basis of a favorable report
from Union Miniere, petitioner began making arrangements to
upgrade his mill capacity. In 1993, petitioner purchased an
induction furnace from Ajax Magnathermic in order to increase the
capacity of his mill from 1 ton per hour to 10 tons per hour.
The purchase price of the induction furnace was about $50,000.
Petitioner made approximately 15 doré bars with the induction
furnace. The induction furnace, however, has not been operated
since 1996.
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secure mineral surveys. Further, beginning in 1991, petitioner
caused various claims to be surveyed with the objective of
patenting those claims. On January 20, 1994, petitioner applied
for a mineral patent for some of his claims.12 To date, however,
petitioner has not received any patents with respect to his
claims.
D. Tinnell Prospect
In 1992 and early 1993, petitioner explored and prospected
an area known as the Tinnell Prospect, consisting of a group of
claims in the northwest corner of petitioner’s claim block.
Horizon Securities, a securities firm that does private
placements for young companies, sent a geologist, Michael
Cruson,13 to perform a geologic evaluation of the area. Mr.
Cruson prepared a report, dated January 15, 1993, and made three
recommendations: (1) No further work is justified on the claims
covered by the Tinnell Prospect; (2) any future work in the area
12
Petitioner claimed that since 1994 there was a moratorium
on the issuance of mineral patents from the BLM. Apparently,
petitioner missed the deadline to apply for a mineral patent by 1
day, and his application was returned to him.
13
Michael Cruson has a geological engineering degree and a
Ph.D. in geology from the Colorado School of Mines. Mr. Cruson
has been engaged in the business of geological engineering since
1973. Mr. Cruson’s clients include major oil companies in the
United States; i.e., Phelps Dodge, Texaco, Chevron, Exxon; and
major mining companies in the United States; i.e., Kenicott,
Mobil, Newmont, and Cypress AMAX. At the time of trial, Mr.
Cruson was conducting a feasability study on the Sarmish gold
deposit site in Pakistan that was discovered in the early 1970's.
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should be to the southeast where documented gold shows are
concentrated;14 and (3) the onsite sample preparation and
assaying methods should be carefully evaluated. As a result of
Mr. Cruson’s recommendations, petitioner abandoned the claims
covered by the Tinnell Prospect. Thereafter, petitioner devoted
his attention to the Quartette Mine.
E. Quartette Mine
From 1991 through March 1996, petitioner pursued the
development and exploration of the Quartette Mine near
Searchlight, Nevada. The Quartette Mine was owned by the Miller
family.15 The Millers were interested in having petitioner lease
their mine so that petitioner could transport rock from the
Quartette Mine to his mill site where it would be crushed and
processed.16
Petitioner hired Mr. Cruson to evaluate the Quartette Mine.
Mr. Cruson prepared a report, dated December 10, 1993, containing
six conclusions and five recommendations. Significantly, Mr.
14
This area was located near petitioner’s mill site (also
known as the Roman mine site) and represents the bulk of
petitioner’s claim area.
15
L.R. Tinnell was married to one of the Millers. They were
divorced by 1993 but remained relatively close.
16
In November 1993, petitioner formed Complex Resources
Development (CRD) to take advantage of the development of the
Quartette Mine and petitioner’s claims. CRD was intended to be
the operating company of a future joint venture controlling the
Quartette mining operations. CRD never became active and never
filed a Federal income tax return.
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Cruson concluded that “The Quartette Mine was a significant
producer of high grade gold ore.” Mr. Cruson recommended that
petitioner: (1) Acquire control of the Quartette Mine; (2) carry
out a detailed geologic study to determine the ore controls and
outline exploration targets; (3) examine the feasibility of
applying new geophysical or geochemical techniques at the
Quartette Mine; (4) develop a detailed history of the Quartette
Mine to determine cutoff grades during production; and (5) test
the targets defined by the earlier geologic study by drilling.
Petitioner followed all the recommendations outlined in Mr.
Cruson’s report.
On April 1, 1994, petitioner17 acquired the rights to mine
and purchase the Quartette Mine ore. Exploratory drilling to
determine the economic viability of the mine was conducted from
September 7 to November 5, 1994. Mr. Cruson and his partner,
Kent E. Carter, prepared an evaluation of the Quartette Mine,
dated January 20, 1995, that stated: “Overall the scout drilling
and exploration program was a resounding success”. Mr. Cruson
“strongly recommended” that petitioner continue excavating, begin
preliminary mine planning, and initiate a second round of
drilling and exploration designed to delineate the new copper-
17
The lease for the Quartette Mine was not made part of the
record, and we assume the parties to the lease were the owners of
the Quartette Mine and petitioner. Nevertheless, because JEI did
not function as a tax reporting entity during the years at issue,
we attribute the mining activities to petitioner.
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gold vein discovery. Mr. Cruson estimated the total budget for
the next phase of drilling would be about $250,000.
Petitioner recovered approximately 4 ounces of gold from the
Quartette Mine, and the project was abandoned in 1996.
F. Petitioner’s Sale of Decorative Rock
After petitioner abandoned his efforts to develop the
Quartette Mine, petitioner expanded his business to include the
sale of decorative rock in an effort to generate revenue. In
1994 and 1995, petitioner “tried to break into the wholesale
market” and realized it was almost impossible. Thereafter,
petitioner opened a “rock yard” for the retail sale of rock and
gravel from his claims. Petitioner purchased an advertisement in
the telephone directory yellow pages. At the time of trial,
petitioner had been selling decorative rock for 4 years.18
During those years, petitioner’s gross income from the sale of
18
When petitioner’s plan of operations was approved, the
BLM, acting in error, granted petitioner permission to dispose of
sand and gravel from what petitioner claimed would be “tailings”
from his placer operations. Subsequently, inspectors from the
BLM observed stockpiles of what appeared to be decorative rock,
and BLM Law Enforcement reported that petitioner was selling
decorative rock in the Las Vegas market. On Feb. 8, 1999, the
Las Vegas Field Office of the BLM sent a decision to petitioner
directing him to halt the sale of “tailings” and “non-locatable”
minerals. On or about Apr. 30, 1999, petitioner filed an appeal
from the BLM decision. Petitioner hired a mining law attorney to
represent him with respect to the BLM’s decision and a geologist
to determine whether petitioner is mining “locatable” minerals.
At the time of trial, the matter was still on appeal, and
petitioner was still selling decorative rock.
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decorative rock has grown steadily, and petitioner continues to
generate substantial income from the sale of decorative rock.
G. Financing of Mining Activities
Petitioner financed most of his mining activity with
royalties from Zila, the sale of Zila stock, and the exercise of
stock options in 1993. Since 1980, no outside investor has
supplied capital for any of petitioner’s mining activities.
Petitioner sold shares of Zila stock when he needed money and
borrowed money secured by his Zila stock.
IV. Petitioner’s Tax Returns
A. Mining Activities
On petitioner’s Federal income tax returns for tax years
through 1997, petitioner treated all of his mining activities as
a single Schedule C activity doing business as Jetco Mining.19
For the years 1980 through 1988, petitioner had no income from
mining activities. During the years from 1989 through 1999,
petitioner reported, either directly on a Schedule C or
indirectly through JEI, gross revenues and expenses from his
mining activities as follows:
19
JEI initially made an election to be treated for tax
purposes as a “pass-through” S corporation but did not file any
tax returns until 1998. Respondent does not assert that any
expenses claimed by petitioner with respect to the taxable years
at issue are disallowable because of the failure of JEI to file
Federal income tax returns.
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Cost of goods
sold and other
Year Revenue cash expenses Depreciation
19891 -0- $113,273 $19,063
1990 -0- 166,786 23,102
2 2
1991 -0- 359,627 41,265
2 2
1992 $700 286,217 41,902
2 2
1993 -0- 400,292 32,829
2 2
1994 2,100 591,704 45,664
1995 2,900 558,142 73,315
1996 -0- 488,521 76,476
1997 32,364 363,923 41,101
3 3
1998 126,170 464,900 93,624
3 3
1999 373,566 322,328 83,960
1
For taxable years 1989 and 1990, petitioner’s original
returns were examined, and no change resulted. For those same
years, petitioner filed amended returns that claimed additional
losses from his mining activities. These claims were examined by
respondent and resulted in loss carryforwards allowed in 1991.
2
The parties agree that these amounts are deductible unless
disallowed by sec. 183. Respondent does not assert that any of
petitioner’s mining expenses with respect to the taxable years
1991 through 1994 should be disallowed as a result of the
application of sec. 616 or 617.
3
Expenses claimed on returns filed on behalf of JEI.
B. Zila Royalties and Stock Options
From 1989 through 1998, petitioner reported royalty income
from Zila as follows:
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Year Royalty Income
1989 $82,933
1990 185,578
1991 213,507
1
1992 180,895
1993 222,439
1994 224,717
1995 277,663
1996 305,002
1997 344,332
1998 372,119
1
Petitioner originally reported $177,169 of royalty income
in 1992. The parties stipulated an increase in this amount to
$180,895.
In 1993, petitioner exercised options to purchase 380,000
shares of Zila stock worth $1,116,250 for an exercise price of
$285,000. After taking into account Zila’s blockage discount of
$282,979, petitioner realized ordinary income of $548,271 on the
exercise of his stock options. On petitioner’s 1993 Federal
income tax return, he claimed an additional discount of $282,979,
asserting that the sale of his Zila shares was restricted.
Petitioner reported the income from the exercise of his Zila
stock options on a supporting schedule attached to his 1993
return and attached an additional schedule fully describing the
total options exercised, the exercise amount, the fair market
value, the exercise price, the per-share blockage discount
applied by Zila, the amount of ordinary income to petitioner
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reported by Zila,20 and the additional discount for restrictions
on stock taken by petitioner (marketability discount). The
schedule contained the following statement concerning the
marketability discount:
THIS DISCOUNT TAKEN BECAUSE TAXPAYER FEELS THAT STOCK
WOULD BE SEVERELY EFFECTED IF HE PUT ALL THESE SHARES
ON MARKET IN ONE BLOCK. IN ADDITION TAXPAYER CANNOT
SELL SHARES FOR THESE YEARS PER SEC REGULATIONS.
THEREFORE, PRESENT VALUE IS LESS.
Petitioner, however, did not make the disclosure on Form 8275,
Disclosure Statement, or Form 8275-R, Regulation Disclosure
Statement. Petitioner and respondent have agreed that petitioner
is entitled to only a single discount of $282,979.
C. Medical Practice
From 1989 through 1998, petitioner reported income and
losses from his medical practice as follows:
Year Income (Loss)
1989 ($10,617)
1990 (15,235)
1991 (3,732)
1992 12,738
1993 36,723
1994 20,574
1995 10,547
1996 8,151
1997 5,449
1998 7,689
20
The additional schedule indicated the amount of
petitioner’s ordinary income as “ORDINARY INCOME-1099". We
assume this indicates that petitioner’s ordinary income was
reported on Form 1099.
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During this period, petitioner spent most of his time and effort
on his mining activities and relatively little time maintaining
his medical practice.
OPINION
I. Section 183(a) Deductions
A. In General
Section 183(a) provides that if an activity is not engaged
in for profit, no deduction attributable to the activity shall be
allowed except as provided in section 183(b). Section 183(b)(1)
allows those deductions that otherwise are allowable regardless
of profit objective. Section 183(b)(2) allows those deductions
that would be allowable if the activity was engaged in for
profit, but only to the extent that gross income attributable to
the activity exceeds the deductions permitted by section
183(b)(1). Section 183(c) defines “activity not engaged in for
profit” as “any activity other than one with respect to which
deductions are allowable for the taxable year under section 162
or under paragraph (1) or (2) of section 212.”
Deductions are allowable under section 162 for the expenses
of carrying on an activity that constitutes a trade or business
of the taxpayer. See sec. 162(a); sec. 1.183-2(a), Income Tax
Regs. To be engaged in a trade or business with respect to which
deductions are allowable under section 162, “the taxpayer must be
involved in the activity with continuity and regularity,” and
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“the taxpayer’s primary purpose for engaging in the activity must
be for income or profit”. Commissioner v. Groetzinger, 480 U.S.
23, 35 (1987); see also Warden v. Commissioner, T.C. Memo. 1995-
176, affd. without published opinion 111 F.3d 139 (9th Cir.
1997).
This case is appealable to the Court of Appeals for the
Ninth Circuit, which applies a primary purpose standard to test
whether an alleged business activity has the requisite profit
motive under sections 162 and 183. Before a deduction is
allowed, “‘it must be shown that the activity was entered into
with the dominant hope and intent of realizing a profit.’”
Vorsheck v. Commissioner, 933 F.2d 757, 758 (9th Cir. 1991)
(quoting Brannen v. Commissioner, 722 F.2d 695, 704 (11th Cir.
1984), affg. 78 T.C. 471 (1982)); see also Wolf v. Commissioner,
4 F.3d 709, 713 (9th Cir. 1993), affg. T.C. Memo. 1991-212;
Machado v. Commissioner, T.C. Memo. 1995-526, affd. without
published opinion 119 F.3d 6 (9th Cir. 1997); Warden v.
Commissioner, supra. We apply that standard here.
Whether the requisite profit objective exists is a question
of fact to be resolved after considering all the pertinent facts
and circumstances. See Golanty v. Commissioner, 72 T.C. 411, 426
(1979), affd. without published opinion 647 F.2d 170 (9th Cir.
1981); sec. 1.183-2(b), Income Tax Regs. The taxpayer’s
expectation of profit need not be reasonable, but it must be bona
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fide. See Golanty v. Commissioner, supra at 425-426. Although
our analysis focuses on the subjective intention of the taxpayer,
greater weight is given to objective facts than to a taxpayer’s
mere statement of intent. See Independent Elec. Supply, Inc. v.
Commissioner, 781 F.2d 724, 726 (9th Cir. 1986), affg. Lahr v.
Commissioner, T.C. Memo. 1984-472; Dreicer v. Commissioner, 78
T.C. 642, 645 (1982), affd. without opinion 702 F.2d 1205 (D.C.
Cir. 1983); Churchman v. Commissioner, 68 T.C. 696, 701 (1977);
sec. 1.183-2(a), Income Tax Regs. Petitioner bears the burden of
proving he had the requisite profit objective. See Rule 142(a);
Golanty v. Commissioner, supra at 426.
Section 1.183-2(b), Income Tax Regs., sets forth a
nonexclusive list of factors to be considered in determining
whether the taxpayer has the requisite profit objective. The
factors are: (1) The manner in which the taxpayer carries on the
activity; (2) the expertise of the taxpayer or his advisers; (3)
the time and effort expended by the taxpayer in carrying on the
activity; (4) the expectation that assets used in the activity
may appreciate in value; (5) the success of the taxpayer in
carrying on other similar or dissimilar activities; (6) the
taxpayer’s history of income or loss with respect to the
activity; (7) the amount of occasional profits, if any, which are
earned; (8) the financial status of the taxpayer; and (9)
elements of personal pleasure or recreation. No single factor is
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determinative, and not all factors are applicable in every case.
See Allen v. Commissioner, 72 T.C. 28, 34 (1979); sec. 1.183-
2(b), Income Tax Regs.
In making our evaluation of the foregoing factors, we may
consider evidence from years subsequent to the years in issue “to
the extent it may create inferences regarding the existence of a
profit motive in the earlier years.” Hillman v. Commissioner,
T.C. Memo. 1999-255 (citing Hoyle v. Commissioner, T.C. Memo.
1994-592). “[A]ctual profits or losses in those and subsequent
years have probative, although not determinative, significance in
such evaluation.” Smith v. Commissioner, T.C. Memo. 1993-140.
Petitioner contends that he had a good faith objective to
realize a profit from his mining activities during the years at
issue and, therefore, his deductions with respect to his mining
activities should not be limited by section 183. Respondent
argues that an analysis of the relevant objective factors reveals
that petitioner lacked a bona fide objective to make a profit.
B. Applying the Factors
1. The Manner in Which Petitioner Conducted the
Activity
In deciding whether a taxpayer has conducted an activity in
a businesslike manner, we consider whether complete and accurate
books and records were maintained, whether the activity was
conducted in a manner substantially similar to other activities
of the same nature that were profitable, and whether changes in
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operating methods, adoption of new techniques, or abandonment of
unprofitable methods were made in a manner consistent with an
intent to improve profitability. See Engdahl v. Commissioner, 72
T.C. 659, 666-667 (1979); sec. 1.183-2(b)(1), Income Tax Regs.
a. Petitioner’s Record Keeping
While a taxpayer need not maintain a sophisticated cost
accounting system, the taxpayer should keep records that enable
the taxpayer to make informed business decisions. See Burger v.
Commissioner, 809 F.2d 355, 359 (7th Cir. 1987), affg. T.C. Memo.
1985-523. For a taxpayer’s books and records to indicate a
profit motive, the books and records should enable a taxpayer to
cut expenses, increase profits, and evaluate the overall
performance of the operation. See Abbene v. Commissioner, T.C.
Memo. 1998-330.
The record in this case confirms that petitioner kept
extensive records of his mining activities, including financial
and tax records such as spreadsheets, bank statements, canceled
checks, and invoices and operational records such as production
records, test reports, consultant reports, correspondence, and
related documents. Petitioner produced these records both to the
revenue agents who audited his tax returns for the years at issue
and to an accountant, Steven Klovanish, whom petitioner hired to
assist him in the audit. Although petitioner and respondent
disagree as to the organizational state of the records, Mr.
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Klovanish testified that petitioner’s records for the years at
issue were in an “organized condition” and, with the exception of
1 year, corresponded with petitioner’s tax returns.21
Although we are satisfied that petitioner kept books and
records of his mining activities during the years at issue, we
are not convinced that petitioner’s record keeping represented
anything other than an effort to maintain substantiation of the
expenses claimed on his returns or that his record keeping was
businesslike. As we have stated:
The purpose of maintaining books and records is
more than to memorialize for tax purposes the existence
of the subject transactions; it is to facilitate a
means of periodically determining profitability and
analyzing expenses such that proper cost saving
measures might be implemented in a timely and efficient
manner. * * * [Burger v. Commissioner, T.C. Memo.
1985-523 (citing Golanty v. Commissioner, 72 T.C. at
430).]
See also Steele v. Commissioner, T.C. Memo. 1983-63 (checks
served as adequate substantiation for claimed expenses but were
not businesslike records).
In this case, petitioner has made no showing that he kept
the kinds of books and records that would have enabled him to
evaluate the financial condition of his mining activities. It
21
Mr. Klovanish could not tie some of the numbers on
petitioner’s tax return for 1 year to petitioner’s records but
suggested that this might be due to the fact that he did not have
information from petitioner’s prior accountant to ascertain what
adjustments the prior accountant had made in preparing the tax
return.
- 24 -
appears from the record that petitioner did not maintain a
general ledger or appropriate accounting journals, nor did he
have financial statements, profit and loss projections, budgets,
break-even analyses, marketing surveys, or other books and
records of the type that would have permitted him to periodically
monitor the financial condition of his mining operation.
Moreover, petitioner has made no showing that he used the books
and records that he did maintain for the purpose of “cutting
expenses, increasing profits, and evaluating the overall
performance of the operation.” Golanty v. Commissioner, supra at
430; see also Sullivan v. Commissioner, T.C. Memo. 1998-367
(generally no profit motive where lack of evidence that taxpayer
used records to improve losing venture), affd. without published
opinion 202 F.3d 264 (5th Cir. 1999).
Petitioner did produce evidence that he submitted a mining
plan of operations that was approved by the BLM on January 12,
1993. This plan of operations, however, was not a financial plan
to monitor the profitability of petitioner’s mining operation.
Rather, the plan of operations was an operational plan required
by law if a claimant wishes to disturb more than 2 acres of land
per year on his claims. Thus, the plan of operations is not
evidence that petitioner kept businesslike financial records.
- 25 -
Petitioner has failed to demonstrate that he maintained
accurate and businesslike books and records with respect to his
mining activities during the years at issue.
b. Similarity to Other Activities of the
Same Nature
Neither petitioner nor respondent offered any evidence as to
the manner in which profitable mining businesses are conducted.
See Wesinger v. Commissioner, T.C. Memo. 1999-372; Filios v.
Commissioner, T.C. Memo. 1999-92, affd. 224 F.3d 16 (1st Cir.
2000); sec. 1.183-2(c), Example (4), Income Tax Regs. Thus, we
are not in a position to evaluate whether petitioner’s mining
activity was conducted in a manner substantially similar to that
of other profitable mining activities.
c. Changes Made To Foster Profitability
There are numerous examples in the record demonstrating that
petitioner made changes in operating methods, adopted new
techniques, and/or abandoned unprofitable methods in the course
of conducting his mining activities. See Engdahl v.
Commissioner, supra at 666-667; sec. 1.183-2(b)(1), Income Tax
Regs.
Petitioner continually increased the capacity of his mill
site and mine (also known as the Roman mine) and periodically
developed or improved the methods he used in his mining activity.
For example, petitioner originally employed a leaching process of
cyanidation for the recovery of precious metals. Petitioner was
- 26 -
not completely satisfied with the leaching process and changed
methods to employ the gravity separation method. In order to
employ this new method, petitioner acquired a jaw crusher, a cone
crusher, a ball mill circuit, a screw classifier, and a wier jig
and table to concentrate material. Petitioner also switched from
using cyanide as a lixiviant in the concentration process to
using bromine, after attending a Landall Mining Symposium in
Reno, Nevada. In early 1993, petitioner purchased a $50,000
induction furnace to improve recoveries through induction
smelting. Petitioner originally had a propane furnace, which was
not powerful enough to melt platinum. Lastly, L.R. Tinnell
developed a proprietary fire assaying method for assaying
refractory ores to augment the standard fire assaying method used
in the industry.
Petitioner pursued several mining prospects but quickly
abandoned those that he concluded had no potential to be
profitable. For example, in Mr. Cruson’s January 15, 1993,
geological report on the Tinnell Prospect, Mr. Cruson recommended
that “No further work is justified on the claims covered by the
Tinnell Prospect.” Pursuant to Mr. Cruson’s recommendation,
petitioner decided to cease work on the Tinnell Prospect. In
1983 and 1984, petitioner pursued a gold mining venture in
Lochiel, Arizona, but quickly abandoned that effort after
realizing the operation would not be profitable. Petitioner then
- 27 -
moved his equipment to Colorado and began another mining
operation, which he also quickly terminated when he discovered he
had been misled.
In 1996, following the loss of the Quartette Mine project,
petitioner began to investigate the sale of decorative rock as an
income source and opened a rock yard in Las Vegas. Petitioner
took out an advertisement in the telephone directory yellow pages
with respect to his decorative rock business. Petitioner’s
revenue from the sale of decorative rock in the 3 years prior to
trial was significant, growing steadily from year to year; i.e.,
$32,364 in 1997, $126,170 in 1998, and $373,566 in 1999.
Petitioner continually searched for operating methods and
business ventures to reduce his losses, generate revenue, and
improve profitability. Ultimately, petitioner was successful in
generating substantial revenue from the sale of decorative rock.
Thus, we are convinced that the changes petitioner implemented
before, during, and after the years at issue have the potential
to affect the long-range profitability of petitioner’s mining
activity materially and favorably. See Golanty v. Commissioner,
72 T.C. at 428 (changes must be sufficient to change materially
the prospect of profitability).
d. Summary
Petitioner’s changes in operating methods, adoption of new
techniques, and abandonment of unprofitable methods to improve
- 28 -
profitability are counterbalanced by petitioner’s failure to
demonstrate that he maintained accurate and businesslike books
and records and to introduce evidence regarding the operation of
successful mining ventures. See Engdahl v. Commissioner, 72 T.C.
at 666-667; sec. 1.183-2(b)(1), Income Tax Regs. We, therefore,
must conclude that this factor is neutral.
2. The Expertise of Petitioner or His Advisers
Preparation for an activity by extensive study of its
accepted business, economic, and scientific practices or
consultation with industry experts may indicate a profit motive
where the taxpayer carries on the activity in accordance with
such practices. See sec. 1.183-2(b)(2), Income Tax Regs.
Petitioner demonstrated that he had a thorough understanding
of the scientific and economic aspects of mining and that he
regularly consulted with industry experts. In 1978, petitioner
began reading prospecting books and became interested in mining.
Petitioner attended shows and seminars about mining and purchased
numerous books on geology and mining. Petitioner also learned
how to read geological mining maps. Petitioner learned about
mining both from self-teaching methods and experience over the
years. Petitioner also did consulting work in or about 1988 with
Kent Kjelberg at the Rattlesnake Mine and provided his expertise
and equipment to help develop the mine.
- 29 -
Petitioner hired advisers, including geologists and
accountants, and sought advice from Government officials
regularly. See Jorgenson v. Commissioner, T.C. Memo. 2000-38.
For example, petitioner used Mr. Cruson on at least two occasions
to advise him on the Tinnell Prospect and the Quartette Mine. In
1999, petitioner hired a geologist to prepare a report detailing
the occurrence of uncommon variety materials on petitioner’s
claims in the Newberry Mountains in southern Nevada.
Petitioner also employed one of his sons at the mine. The
evidence demonstrates that L.R. Tinnell has a thorough
understanding of both the technical and business aspects of
mining. L.R. Tinnell graduated from the University of Nevada,
Las Vegas, and also took a graduate-level course in economic
geology. L.R. Tinnell was responsible for dealing with
Government agencies, such as the U.S. Fish and Wildlife Service,
the Nevada Department of Environmental Protection, and the Mine
Safety and Health Administration, on behalf of petitioner. L.R.
Tinnell was also in charge of underground mining and tests,
negotiations with Government agencies, and coordinating assays.
This factor favors petitioner.
3. Petitioner’s Time and Effort Devoted to the
Activity
The fact that a taxpayer devotes personal time and effort to
carry on an activity may indicate an intention to derive a
profit, particularly where there are no substantial personal or
- 30 -
recreational elements associated with the activity. See Daley v.
Commissioner, T.C. Memo. 1996-259; sec. 1.183-2(b)(3), Income Tax
Regs. A taxpayer’s withdrawal from another occupation to devote
most of his energies to the activity may be evidence that the
activity was engaged in for profit. See sec. 1.183-2(b)(3),
Income Tax Regs.
Respondent does not dispute that petitioner devoted a
substantial amount of time and effort to his mining activities.
In or about 1988, petitioner began to disengage from his
pharmaceutical and medical activities and to spend more time in
his mining activity. Petitioner estimated he spent about 90
percent of his time on mining and only 10 percent of his time
working in his medical practice during the years at issue.
Petitioner’s estimate is corroborated by the small amount of
revenue petitioner derived from his medical practice in the 10
years prior to trial. Further, the record demonstrates that
petitioner spent an enormous amount of his time, personal
finances, and energy over the past 20 years on his mining
activities.
This factor favors petitioner’s position.
4. The Expectation That Assets Used in the Activity
Would Appreciate in Value
The term “profit” encompasses revenue from operations and
appreciation in the value of assets, such as land. Sec. 1.183-
2(b)(4), Income Tax Regs.
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Thus, the taxpayer may intend to derive a profit from
the operation of the activity, and may also intend
that, even if no profit from current operations is
derived, an overall profit will result when
appreciation in the value of land used in the activity
is realized since income from the activity together
with the appreciation of land will exceed expenses of
operation. * * * [Id.]
Petitioner presented insufficient evidence to enable us to
evaluate this factor adequately. Consequently, we do not
consider this factor in our analysis.
5. Petitioner’s Success in Other Entrepreneurial
Activities
That a taxpayer has engaged in similar activities in the
past and converted them from unprofitable to profitable
enterprises may indicate that the taxpayer is engaged in the
present activity for a profit, even though the activity is
presently unprofitable. See sec. 1.183-2(b)(5), Income Tax Regs.
The record demonstrates that petitioner had at least two
successful entrepreneurial ventures before commencing his mining
activities. First, in or about 1973, petitioner and his father
purchased Delta Roofing Mills, a roofing manufacturing business
in Slidell, Louisiana, for approximately $1 million. Within 5
years, petitioner and his father tripled the company’s gross
sales and sold it to Republic Gypsum Corp. for approximately $3
million.
Second, during the late 1970’s, petitioner invented the
cream. In September 1980, petitioner and his partner formed Zila
- 32 -
Pharmaceuticals, Inc., which later became a wholly owned
subsidiary of Zila. At the time of trial, Zila had over 200
employees and a market capitalization of approximately $200
million. The cream, which is now called Zylactin, is still on
the market as an over-the-counter treatment for herpes, and
petitioner has received substantial royalties from his invention.
The record demonstrates that petitioner has realized profits
from other successful business ventures. This factor favors
petitioner’s position.
6. Petitioner’s History of Income or Loss
From the Activity
A taxpayer’s history of income or loss with respect to any
activity may indicate the presence or absence of a profit
objective. See Golanty v. Commissioner, 72 T.C. at 426; sec.
1.183-2(b)(6), Income Tax Regs. The magnitude of the activity’s
losses in comparison with its revenues is an indication that the
taxpayer did not have a profit motive. See Dodge v.
Commissioner, T.C. Memo. 1998-89 (citing Burger v. Commissioner,
809 F.2d at 360), affd. without published opinion 188 F.3d 507
(6th Cir. 1999). “[A] series of startup losses or losses
sustained because of unforeseen circumstances beyond the control
of the taxpayer may not indicate a lack of profit motive.” Kahla
v. Commissioner, T.C. Memo. 2000-127 (citing Engdahl v.
Commissioner, 72 T.C. at 669; sec. 1.183-2(b)(6), Income Tax
Regs.).
- 33 -
In this case, petitioner’s losses in comparison with his
revenues are substantial. From 1980 through 1991, petitioner did
not report any income from his mining activities, and from 1989
through 1991, petitioner reported $723,656 in net losses. From
1992 through 1999, petitioner reported a total of $537,800 in
revenue and $3,347,724 in losses.
This factor favors respondent’s position.
7. The Amount of Occasional Profits Generated
by the Activity
The amount of profits earned in relation to the amount of
losses incurred, the amount of the investment, and the value of
the assets in use may indicate a profit objective. See sec.
1.183-2(b)(7), Income Tax Regs. Profit means economic profit,
independent of tax savings. See Drobny v. Commissioner, 86 T.C.
1326, 1341 (1986); Seaman v. Commissioner, 84 T.C. 564, 588
(1985).
Petitioner conceded on brief that he did not realize any
economic profit until 1999 and only began generating “meaningful
revenue” in 1997.22 Petitioner contends, however, that section
1.183-2(b)(7), Income Tax Regs., best describes his mining
22
During the years at issue in this case, petitioner
reported over $1.6 million in costs and expenses related to his
mining activities and only $2,800 of revenue. In the subsequent
5 years, however, petitioner reported $535,000 in revenue and
approximately $2.2 million in costs and expenses. In 1999,
petitioner’s revenue of $373,566 surpassed his operating costs
and expenses of $322,328, exclusive of depreciation.
- 34 -
activity: “[A]n opportunity to earn a substantial ultimate
profit in a highly speculative venture is ordinarily sufficient
to indicate that the activity is engaged in for profit even
though losses or only occasional small profits are actually
generated.” Respondent’s argument on brief with respect to this
factor consisted solely of the following sentence: “The
petitioner has never reflected a profit from his mining activity,
and his losses have been substantial.”
A mining venture is speculative and may take years to
realize a profit. A mining venture nevertheless may present an
opportunity to earn substantial profits, particularly if the
mining claims involved have “high mineral potential” as at least
some of petitioner’s claims apparently did. Petitioner presented
the testimony of an expert geologist who confirmed that
petitioner’s efforts with respect to the Quartette Mine were
worth pursuing and that some of petitioner’s claims merited
development. While speculative, petitioner’s mining activity
offered the potential to generate significant income, and that
possibility may be sufficient to indicate that petitioner engaged
in the activity for profit even though only losses were produced.
See sec. 1.183-2(b)(7), Income Tax Regs.
Petitioner believed he could and would earn a profit from
his many activities. The objective facts also support
petitioner’s contention that a profit was attainable. In 6 of
- 35 -
the 8 years prior to trial, petitioner earned revenue on sales of
decorative rock in increasing amounts. Petitioner testified that
he continued to generate revenue from sales of decorative rock in
2000 and that his gross revenue during the first 2 months of 2000
was approximately $55,000, an increase of 200 percent compared to
revenue earned in the first 2 months of 1999. Referencing the
“Resource Management Plan” map prepared by and for the BLM that
acknowledged the “high mineral potential” on and around
petitioner’s mining claims, petitioner testified that
there is “absolutely” gold and silver on his claims and that he
intends to “go back to the gold when the price turns”.
The possibility of a speculative profit becomes less
speculative when a taxpayer shows he actually realized a profit
in years subsequent to those at issue. See Hillman v.
Commissioner, T.C. Memo. 1999-255; Hoyle v. Commissioner, T.C.
Memo. 1994-592; Smith v. Commissioner, T.C. Memo. 1993-140
(actual profits or losses in subsequent years have probative,
although not determinative, significance). Here, petitioner’s
efforts to generate revenue from the production and sale of
decorative rock are succeeding, as revenue has increased steadily
each year, and in 1999 petitioner’s mining activities generated a
profit before depreciation. This factor favors petitioner’s
position.
- 36 -
8. Petitioner’s Financial Status
That the taxpayer does not have substantial income or
capital from sources other than the activity in question may
indicate that the activity is engaged in for profit. See sec.
1.183-2(b)(8), Income Tax Regs. Substantial income from sources
other than the activity (especially if the losses from the
activity generate substantial tax benefits) may indicate a lack
of profit motive, particularly where there are elements of
personal pleasure or recreation involved. See id.
Respondent argues that little financial pressure or
incentive existed to pursue work that was consistently profitable
because petitioner could fund his mining activities with the
royalties he received from Zila and with the proceeds from the
sale of Zila stock.23 Petitioner contends that the tax benefits
he realized were relatively small in comparison to the out-of-
pocket expenditures he made and that his financial commitment to
his mining activity confirms his intention to make a profit from
the activity.
Petitioner’s income from Zila royalties and stock was
substantial during the years at issue; however, petitioner
invested a substantial portion of that money each year in his
mining activities. Petitioner financed his mining activity with
23
With respect to his medical practice, however, petitioner
did not earn more than $36,723 in any year from 1989 through
1998, and he sustained losses in 3 of those years.
- 37 -
Zila royalties and from the sale of Zila stock. Petitioner sold
his Zila stock as he needed money and borrowed money that was
secured by his Zila stock.
By the time of trial, petitioner had sold most of his Zila
stock and had used the proceeds from the sale of the stock and
all of his Zila royalties for many years to fund his mining
activity. Petitioner’s financial commitment to his mining
activity apparently led respondent to concede in his reply brief
that it “is probably true” petitioner’s mining expenditures were
not motivated by tax savings.
This factor favors petitioner’s position.
9. Elements of Personal Pleasure or Recreation
The existence of personal pleasure or recreation relating to
the activity may indicate the absence of a profit objective. See
sec. 1.183-2(b)(9), Income Tax Regs.
Petitioner argues that mining is not the sort of activity a
person engages in for personal pleasure and that the frustrations
in dealing with Federal, State, and local government regulatory
agencies and the harsh working conditions offset any elements of
personal pleasure derived from mining. Respondent contends that
personal enjoyment can coexist with demanding labor and that
petitioner loves being at the mine and is tired of working with
sick people.
- 38 -
The record confirms that mining is an extremely laborious
activity that requires substantial time, energy, and financial
support. Mining also entails numerous health risks, including
heat prostration in the summer months, silicosis, and cyanide
poisoning. Despite these risks and hardships, there is evidence
suggesting that petitioner derives some personal pleasure from
his mining activities. During the audit and at trial, petitioner
acknowledged that he enjoyed being outdoors, and that he was
“tired of dealing with sick people”.
On balance, we are convinced that the small element of
personal pleasure that petitioner derived from being outdoors and
from his reduced involvement in his medical practice did not
outweigh the hardships and danger involved in the mining activity
or the substantial depletion of petitioner’s royalty income and
Zila stock. Moreover, some component of personal pleasure does
not negate a bona fide profit motive. “[A] business will not be
turned into a hobby merely because the owner finds it
pleasurable; suffering has never been made a prerequisite to
deductibility. ‘Success in business is largely obtained by
pleasurable interest therein.’” Jackson v. Commissioner, 59 T.C.
312, 317 (1972) (quoting Wilson v. Eisner, 282 F. 38, 42 (2d Cir.
1922)); see also sec. 1.183-2(b)(9), Income Tax Regs.
This factor favors petitioner’s position.
- 39 -
C. Conclusion
After considering the factors listed in section 1.183-2(b),
Income Tax Regs., all contentions presented by the parties, and
the unique facts and circumstances of this case, we conclude that
petitioner entered into the activity of mining with a dominant
hope and intent of realizing a profit. See Wolf v. Commissioner,
4 F.3d at 713; Vorsheck v. Commissioner, 933 F.2d at 758; Machado
v. Commissioner, T.C. Memo. 1995-526; Warden v. Commissioner,
T.C. Memo. 1995-176. We hold that petitioner’s mining activity
during the years in issue was an activity engaged in for profit
within the meaning of section 183.
II. Section 6662(a) Penalty
In his notices of deficiency, respondent determined that
petitioner was liable for an accuracy-related penalty due to
negligence or disregard of rules or regulations for each of the
years in issue. Section 6662 authorizes respondent to impose an
accuracy-related penalty equal to 20 percent on the portion of an
underpayment attributable to, among other things, negligence or
disregard of rules or regulations. See sec. 6662(a), (b)(1), and
(c). “Negligence” includes any failure to make a reasonable
attempt to comply with the provisions of the internal revenue
laws, to exercise ordinary and reasonable care in the preparation
of a tax return, to keep adequate books and records, or to
substantiate items properly. Sec. 6662(c); Allen v.
- 40 -
Commissioner, 925 F.2d 348, 353 (9th Cir. 1991), affg. 92 T.C. 1
(1989); Bunney v. Commissioner, 114 T.C. 259, 266 (2000); sec.
1.6662-3(b)(1), Income Tax Regs. The term “disregard” includes
any careless, reckless, or intentional disregard. Sec. 6662(c);
sec. 1.6662-3(b)(2), Income Tax Regs.
The penalty imposed by section 6662(a) and (b)(1) will not
apply if a taxpayer shows there was reasonable cause for any
portion of an underpayment and the taxpayer acted in good faith
with respect to that portion. See sec. 6664(c)(1); sec. 1.6664-
4(a), Income Tax Regs. The determination of whether a taxpayer
acted in good faith is made on a case-by-case basis, taking into
account all the pertinent facts and circumstances. See Compaq
Computer Corp. v. Commissioner, 113 T.C. 214, 226 (1999); sec.
1.6664-4(b)(1), Income Tax Regs.
Petitioner bears the burden of proving that respondent’s
determination is erroneous. See Rule 142(a); Allen v.
Commissioner, 925 F.2d at 353; Axelrod v. Commissioner, 56 T.C.
248, 258 (1971).
A. Stipulated and Computational Issues
Respondent proposed several adjustments with respect to
petitioner’s returns for the years in issue. Some of the
adjustments were settled before trial, as reflected in the
stipulations of settled issues, or are computational. See supra
note 2. Petitioner introduced evidence at trial, and argued on
- 41 -
brief, in support of his position that the accuracy-related
penalty should not be imposed with respect to the mining
deductions or the exercise of Zila stock options. Petitioner,
however, did not present any evidence concerning the accuracy-
related penalty as it relates to the remaining settled or
computational issues. Consequently, we hold that petitioner has
failed to prove that the accuracy-related penalty should not
apply with respect to the remaining settled and computational
issues. See Rule 149(b). We sustain respondent’s determination
as to the settled and computational issues, excluding only the
adjustment with respect to petitioner’s exercise of his Zila
stock options discussed separately below.
B. Exercise of Zila Stock Options
In 1993, petitioner was required to report ordinary income
of $548,271 from his exercise of stock options to purchase
380,000 shares of Zila, after taking into account an exercise
price of $285,000 and Zila’s per-share blockage discount of
$282,979. On petitioner’s 1993 Federal income tax return,
however, he reduced the amount of ordinary income derived from
his exercise of his Zila stock options (and shown on a Form 1099
issued to him) by an additional $282,979, claiming that he was
entitled to an additional discount because the sale of the shares
was restricted. Petitioner disclosed this additional discount on
a schedule that fully described the total options exercised, the
- 42 -
exercise amount, the fair market value, the exercise price, the
per-share blockage discount applied by Zila, the amount of
ordinary income reported on Form 1099, and the additional
discount for restrictions on stock taken by petitioner
(marketability discount). The schedule contained the following
statement concerning the marketability discount:
THIS DISCOUNT TAKEN BECAUSE TAXPAYER FEELS THAT STOCK
WOULD BE SEVERELY EFFECTED IF HE PUT ALL THESE SHARES
ON MARKET IN ONE BLOCK. IN ADDITION TAXPAYER CANNOT
SELL SHARES FOR THESE YEARS PER SEC REGULATIONS.
THEREFORE, PRESENT VALUE IS LESS.
In the second Stipulation of Settled Issues filed with the Court,
petitioner and respondent agreed that petitioner is entitled to
only one discount of $282,979 and that, in 1993, petitioner
understated ordinary income from the exercise of Zila stock
options by $282,979.
The applicable regulations regarding the accuracy-related
penalty as to negligence, which became effective for returns due
after December 31, 1991, and applied to returns filed for 1993,
contained an adequate disclosure exception. See sec. 1.6662-
2(d), Income Tax Regs. These regulations provided that no
penalty under section 6662(a) and (b)(1) will be imposed where a
taxpayer has made an adequate disclosure of a nonfrivolous
position in accordance with the provisions of section 1.6662-
4(f)(1), (3), (4), and (5), Income Tax Regs. See secs. 1.6662-1,
1.6662-3(c)(1) and (2), Income Tax Regs. Under the regulations,
- 43 -
disclosure was adequate with respect to an item or a position on
a return only if it was made on Form 8275 or Form 8275-R attached
to the return or to a qualified amended return for the taxable
year. See Kelly v. Commissioner, T.C. Memo. 1996-529; sec.
1.6662-4(f)(1), Income Tax Regs.24
The disclosure petitioner made on his 1993 return did not
satisfy the regulations’ definition of an adequate disclosure
and, thus, is insufficient to avoid the accuracy-related penalty
under section 6662(a) and (b)(1). The regulations explicitly
state that an adequate disclosure statement for purposes of the
accuracy-related penalty as to negligence must be made on Form
8275 or Form 8275-R. See Kelly v. Commissioner, supra; sec.
1.6662-4(f)(1), Income Tax Regs. Petitioner did not attach a
Form 8275 or Form 8275-R to his 1993 return and, therefore,
24
For returns due before Dec. 31, 1991, taxpayers were
entitled to rely on Notice 90-20, 1990-1 C.B. 328, which states
that “disclosure must be full and substantive and be clearly
identified as being made to avoid imposition of the accuracy-
related penalty.” See also Kelly v. Commissioner, T.C. Memo.
1996-529. Notice 90-20, supra, also provided that “The
disclosure must be made on the return or on a properly completed
Form 8275, Disclosure Statement Under Section 6661, attached to
the return.” Sec. 1.6662-4(f)(1), Income Tax Regs., in effect
for 1993, sets forth stricter requirements than those set forth
in Notice 90-20, supra, in order to avoid the imposition of the
accuracy-related penalty under sec. 6662(a) and (b)(1).
In addition, the provisions of sec. 1.6662-4(f)(2), Income
Tax Regs., which permit disclosure in accordance with an annual
revenue procedure for purposes of the substantial understatement
penalty, do not apply for purposes of the accuracy-related
penalty imposed for negligence. See sec. 1.6662-3(c)(2), Income
Tax Regs.
- 44 -
failed to meet the strict requirements of sections 1.6662-3(c)(1)
and (2) and 1.6662-4(f)(1), Income Tax Regs.
Even though petitioner did not make an adequate disclosure
sufficient to avoid the penalty under the applicable regulations,
petitioner may still be relieved of liability for the accuracy-
related penalty if he shows there was reasonable cause for the
understatement and he acted in good faith with respect to the
understatement. See sec. 6664(c); sec. 1.6664-4(a), Income Tax
Regs. We decide whether petitioner acted with reasonable cause
and in good faith after reviewing all the facts and circumstances
and taking into account a variety of factors. See sec. 1.6664-
4(b), Income Tax Regs. The most important factor is the extent
of petitioner’s effort to assess his proper tax liability. See
sec. 1.6664-4(b)(1), Income Tax Regs.
Petitioner contends that he claimed the additional
marketability discount after consultation with his accountant and
that, at all times, he “reasonably relied upon the expertise and
advice of a certified public accountant in the preparation and
filing of” his tax return.25 The only evidence petitioner
25
Petitioner also argued that any understatement
attributable to an undervaluation of the Zila stock should be
reduced if (i) the tax treatment is supported by substantial
authority, or (ii) there was adequate disclosure of relevant
facts on his return. See sec. 6662(d)(2)(B). By its terms, and
as indicated by the regulations, the exception in sec.
6662(d)(2)(B) applies only to an accuracy-related penalty imposed
on an underpayment attributable to any substantial understatement
(continued...)
- 45 -
presented to indicate that he “reasonably relied upon the
expertise and advice” of his accountant, however, was his own
self-serving testimony, which we are not required to accept. See
Tokarski v. Commissioner, 87 T.C. 74, 76 (1986). Petitioner’s
1993 return does not indicate that the marketability discount was
taken on the advice of his accountant or that petitioner
consulted his accountant. Further, there is no evidence that
petitioner retained an expert to value the stock before claiming
the marketability discount. To the contrary, the schedules
indicate that the additional discount was taken because
petitioner felt that the stock was restricted and that an
additional discount was warranted.26
We find that petitioner has failed to prove that there was
reasonable cause for the understatement and that he acted in good
faith in applying an additional discount to reduce the value of
the Zila stock acquired by exercising his stock options. We
hold, therefore, that petitioner is liable for an accuracy-
related penalty with respect to the additional income generated
by the exercise of his Zila stock options.
25
(...continued)
of income tax. See sec. 6662(b)(2), (d)(2)(B); sec. 1.6662-4(a),
Income Tax Regs.
26
Petitioner’s reporting position regarding the additional
discount was inconsistent with the Form 1099 furnished by Zila,
which allowed a blockage discount of only $282,979.
- 46 -
III. Conclusion
We have considered the remaining arguments of both parties
for results contrary to those expressed herein and, to the extent
not discussed above, find those arguments to be irrelevant, moot,
or without merit.
To reflect the foregoing,
Decision will be entered
under Rule 155.